Tony Blair can relax: the police are closing their investigation into him. I refer to the North Wales constabulary which has decided to wind up its inquiry into the allegation that the Prime Minister was guilty of uttering a racist remark by swearing about the 'fucking Welsh.' That police investigation was always treated as a joke. And so was another much more serious inquiry about which Mr Blair cannot be relaxed. Until the sensational developments of the past few days, the cash-for-coronets affair had been treated by the political class with some levity. The furore over party funding was self-evidently damaging to the government in general and to Tony Blair especially. But few were the politicians, whether they were Labour, Tory or Lib Dem, who thought that there was any real prospect of the chilly hand of the law feeling anyone's sweaty collar. Westminster expected that investigation to end not with the bang of a cell door, but with a sigh from the police saying they couldn't find enough evidence to bring anyone to trial.

It could still conclude that way. No one has been charged with anything yet; everyone is protesting their innocence of illegality. But last week's arrest of Lord Levy, not only the Prime Minister's chief fund-raiser, but also a close and long-time friend, has been an electric shock to Westminster and the cosy and complacent assumption that the police wouldn't get anywhere serious. As he has been ceaselessly and mockingly reminded, Tony Blair was once so foolish as to claim that he would be 'whiter than white'. Since Michael Levy's arrest, faces around the Prime Minister have turned greyer than grey. A total of 48 people have so far been questioned by the metropolitan police's specialist crimes directorate; 13 of the interviews have been under caution. A former Labour party chairman, a minister and some of the Number 10 officials closest to Mr Blair have - or will be - interrogated by detectives. 'Do you know a good lawyer?' is a phrase anxious people in government may be muttering to each other for some months.

The police have already filed two preliminary reports with the crown prosecution service. The final report, on which the CPS will decide whether or not to bring prosecutions, is expected to be delivered in September on the eve of the Labour party conference in Manchester. If charges are brought at that point, they will have an absolutely incendiary effect just as Tony Blair is about to face what was already promising to be a extremely febrile gathering of his party.

John Yates, the deputy assistant commissioner leading the investigation, gave the strong impression that he wants to interview Tony Blair when the police officer had a private session with MPs on the public administration committee. This takes us into realms that modern British politics has never previously visited. We may think we have seen it all; we ain't. In America, they are familiar with presidents being grilled by special prosecutors. In Italy, investigating magistrates are the scourges of the political classes, as Mr Tessa Jowell has found out. For Britain, police investigation of a sitting prime minister has no precedent in the modern age.

This marks both a huge escalation in the seriousness of this affair and underlines why it is distinctive from the sleaze episodes during the premiership of John Major. The characters in the immorality plays of the Major years were, for the most part, obscure backbenchers and low-order ministers who only became famous for being infamous. Even his nastiest enemies never alleged that John Major was personally involved in anything corrupt. He was damaged by sleaze because he was made to look too feeble to deal with the cheats and crooks crawling about in it in the Tory party.

This is of a quite different scale. The police are knocking on the door of Number 10 itself. Tony Blair has recorded many firsts in his time as Prime Minister. It now seems highly likely that he will soon become the first British Prime Minister since David Lloyd George to be interviewed by the police in a corruption investigation.

When I ask members of the cabinet and senior aides at Number 10 how they think this will all end, they groan hopelessly that they have no idea. 'We're completely in the dark,' says one senior Downing Street official. Their panic and bewilderment is palpable. None of the usual plays in the political manual are of much use to cope with this. Over the Blair years, Number 10 has had plenty of practice being accused of scandal. The customary response from the machine is to whirr into damage limitation mode. There is a graveyard of cabinet ministers who were dispensed with when the headlines grew too hot to handle.

Distancing the Prime Minister from the allegations is not an option in this case. He cannot pretend that Lord Levy, his tennis partner and Middle East envoy as well as jolly swagman, is someone he hardly knows who was engaged in activities about which Number 10 was wholly ignorant. Everyone refers to Lord Levy as the pop promoter with a talent for squeezing large sums out of very rich men. It is often forgotten that Michael Levy is, by training, an accountant. He will not only know where the bodies are buried. He will have precise grid references.

Lord Levy is letting it be known that he is not going to be the scapegoat for this affair. He's told friends that it wasn't his idea to bankroll the Labour party's last election campaign using undisclosed loans worth nearly £14 million. On the account that Lord Levy appears to have been giving to his friends to supply to the media, it was the Prime Minister who over-ruled him by insisting that Labour should raise its moolah that way.

A defence that they have tried to muster is that the Tories were at it first and have been worse. Andrew Tyrie, a Conservative MP who has long been concerned about what party funding has done to our politics, has said quite candidly: 'I have no doubt that people who, in the past, [have] given money, one way or another to the Conservative party, have benefited from that by being given honours.'

That explains why the Tory pursuit of the allegations against Labour has not been very aggressive. But as Mr Blair's more realistic friends have to admit, it is no defence, in politics or in the law, to say that others behaved no better. 'Guilty, but not quite as guilty as the Tories' is not a plea in mitigation that works with the jury of public opinion, never mind in a court. It is always more politically toxic to be embroiled in scandal when you are the governing party. One political technique for trying to deal with scandal is to try to accuse the accuser. But it is not going to be credible for the government to suggest that Mr Blair is in some way the victim of an anti-Labour conspiracy by the police. Not when the detectives have actually interviewed more Tories than they have Labour people.

David Blunkett did not allege a plot when he went on to the airwaves, but the former Home Secretary did suggest that the police were grandstanding by making a 'theatrical' arrest of Lord Levy. Perhaps it is not a coincidence that the arrest happened the day before Mr Yates had his private, but very well-briefed, session with the public administration committee to whom he needed to demonstrate that the police inquiry was making progress in order to deter the MPs from interviewing potential witnesses and suspects. Mr Yates expressed himself as very cross with the suggestion that the arrest was just a bit of amateur dramatics. That encounter between police officer and politicians emphasises the danger of trying to spin against the police.

It is not a question of whether there can be a good outcome for the government from this. It is a question of just how bad it is going to be. In the best-case scenario for Tony Blair, no one ends up in court. Even then, many voters are already entrenched in the belief that something rotten has gone on. The wild west adventures of John Prescott, The Man With No Shame, suggest a government living in Dodge City. Now the Loan Ranger of Number 10 has seen one of his best friends arrested, and all for a fistful of dollars.

Tony Blair will have to live with the accusation that his is a decadent government. What he and those closest to him will find most frightening is that the course of events is now so out of their control. New Labour has lived by the belief that the most essential thing in politics is to be able to shape the narrative, to be in charge of how a story begins, how it develops and how it climaxes. In the face of this, they are at a loss. 'I can't think of anything we could do. There's no tactic I can think of that can be deployed,' laments one of the Prime Minister's closest confidants. 'No one thought it would come to this and no one knows where it is going.'

Worst of all for them, they cannot know where it will end. They can only sniff the air and guess that it will not be happily.

· In the Public Affairs awards, Andrew Rawnsley was last week voted Political Journalist of the Year.